The accounting equation is the foundation of double-entry accounting. It shows the relationship between a company’s assets, liabilities, and equity. Business is run through transactions, which are financial events that increase or decrease assets, liabilities, or equity. A business gets funds from owners and creditors and uses them to buy assets. This means that assets always equal liabilities plus equity.
Assets = Liabilities + Equity
Key Components in the Accounting Equation
1. Assets: Things a business owns that have value and help it earn money. They are not meant for sale. Expenditure that occurred in acquiring these valuable articles is also considered as asset. Assets can be of different types I.e. Fixed, Floating, Fictitious, Intangible, and Liquid. Assets are purchased to increase the earning capacity of the business.
Some of the assets are as follows: Cash in Hand, Cash at Bank, Sundry Debtors, Bills Receivables, Investments, Plant & Machinery, Equipment and Tools, Furniture and Fittings, Closing Stock, Prepaid Expenses, Accrued Income, Etc.
2. Liabilities: Amounts a business owes to outsiders. They are claims on the business’s assets by creditors. Liabilities can include creditors for goods (like Sundry Creditors, Bills Payable), creditors for expenses (like Outstanding Salaries, Rent Due), other liabilities (like Bank Loans, Overdrafts, Partner’s Loans).
3. Equity: Amount invested by owners in the business whether in cash or kind is called Equity or capital. Equity can also be described as the owner's claim against the assets of the business or the Owner's Fund. It can be in the form of capital, Reserve, General Reserve, or Reserve Fund, Profit or Retained Earning, Interest on Capital
Accounting Equation Calculation
Transaction 1: Nupur started a business with cash $20,000.
Transaction 2: Purchase of goods worth $50,000 on credit.
Transactions | Account Affected | Nature of Account | Effect | Amount |
|---|---|---|---|---|
Nupur started a business with cash $20,000 | Cash | Assets | Increase | 20,000 |
Capital | Capital | Increase | 20,000 | |
Purchase of goods worth $50,000 on credit | Stock | Assets | Increase | 50,000 |
Creditors | Liabilities | Increase | 50,000 |
These will affect the accounting equation as follows:
Rule of Debit and Credit ( Under Modern Approach)
Under the Modern approach, all the accounts are classified into the following five categories mentioned below:
1. Assets Account: An increase in the amount of any asset is recorded on the debit side of the assets account whereas any decrease in the amount of an asset will be recorded on the credit side of the asset account.
2. Liabilities Account: When there is an increase in any of the liabilities, it is recorded on the credit side of that particular liability and when there is a decrease in the liability, it is recorded on the debit side of the liabilities account.
3. Capital Account: An increase in the capital is recorded on the credit side and the decrease in the capital is recorded on the debit side.
4. Revenue or Income Account: All increases in the gains and incomes will be recorded on the credit side as it leads to an increase in capital and all decreases in the gains and income will be debited in that particular account as it reduces capital.
5. Losses or Expenses Account: All increases in the losses and expenses are recorded on the debit side and all decreases in the losses and expenses will be recorded on the credit side.